Back in June we sent out two Financially Speaking newsletters detailing our thoughts on recession. At the time we felt we would not see a recession in 2022, but that a recession in 2023 was a real possibility. The latest updates to this recession discussion came on Wednesday, July 13 when the Bureau of Labor Statistics (BLS) announced inflation in June increased +9.1% from the year before. Then on Thursday, July 28 the Bureau of Economic Analysis (BEA) released its advanced estimate of second quarter Gross Domestic Product (GDP). That estimate came in at -0.9% and was the second consecutive quarter of negative GDP. Both reports came as somewhat of a shock. For many of us the BEA report spells recession because we have been trained over the years to think of two consecutive quarters of negative GDP as equaling a recession. For today’s Financially Speaking we want to look more closely at the current economic conditions and evaluate what we think is happening and why. As always, the team at Barron Financial Group are only a phone call or email away if you have further questions or prefer a personal discussion.
Recession – Who Decides?
Although it is absolutely true that two consecutive quarters of negative GDP were historically considered a recession, that is not an absolute definition. Technically, the National Bureau of Economic Research (NBER) is tasked with determining if the U.S. is, or is not, in a state of recession. And given the current economic conditions, we think this is an important point. For starters, the two negative quarters of GDP did frequently illustrate recession when looking at normal, cyclical economic conditions. But, current economics aren’t following a traditional cyclical path of weakening or bottoming after a period of strengthening or peaking. For the last two and one-half years our economy has been tethered to the pandemic and its aftermath. A good illustration comes by looking at the investment markets. In the second half of 2021 the S&P 500 was up +13%, then in the first half of 2022 the S&P 500 was down -15%. That looks nothing like a normal cyclical transition from a peaking economy to a weakening economy. From our point of view, we do not believe the U.S. is in a state of recession right now. Our arguments are based on the very strong economic data we see. Employment was up over +450,000 per month in the first half of 2022. Industrial production is up over +5% in the first half of 2022. Corporate revenues and profits continue to beat last year by more than 70% of companies. These are not the kind of economic data you would see from a country that is in recession. Instead, we feel this economy continues to adjust from the pandemic and the +40% increase in the M2 money supply over the course of 2020 and 2021. That, we believe, is what is driving inflation right now, and elevated inflation is what is causing GDP to contract in specific sectors, but not a broader recession. I expect we will see a release from the NBER soon giving us a final decision on U.S. recession. One additional point: if we are right that this economy is not following the normal, cyclical path and is not in recession, then we would argue that the recession of 2020, shortly after the pandemic was announced, was also not a real, traditional cyclical recession. Instead, we believe that was an economic contraction based on the unprecedented pandemic lockdowns happening across the country. The NBER has confirmed it was a recession, but we don’t fully agree.
Where to Now?
The Federal Reserve (Fed) is purposely trying to reduce inflation. Truth told, the Fed has a visceral dislike of inflation and its long-term, deleterious effects. Inflation, along with the other two major issues from our previous newsletter, the labor market and the supply chain, are critical elements to our economy and its adjustment from the pandemic. The Fed knows that aggressively raising interest rates could lead to recession, but it’s a risk they are willing to take. They raised rates by 0.75% in both June and July, bringing today’s Fed Funds interest rate to 2.25-2.50%. The Fed Chairperson, Jerome Powell, suggested this level may be near the neutral rate (the rate at which interest rates are not boosting or contracting economic activity) and if they keep raising rates as expected that would put interest rates above the neutral rate, which would potentially lead to recession. Expectations right now are for a 0.50% increase at the September meeting and a 0.25% rate for November. That would leave the Fed Funds rate at 3.00-3.25%. We feel those projections are reasonable, if not somewhat conservative. We feel this will lead to recession in 2023 as consumers, homebuyers and corporations contract spending in response to higher interest rates. But that recession will alleviate much of the inflation burden. In the meantime, we feel a partial recovery in the stock market later this year is possible as the inflation story starts to get “less bad”.
Thus, we do not feel the U.S. is in a recession now, although we admit that two quarters of negative GDP is disturbing. We feel the underlying economy is strong, but adjustments are taking place due to rising interest rates and post-pandemic conditions. And these adjustments can be messy. We further believe rates will continue to increase because the Fed is fully committed to defeating inflation. And this process will likely lead to recession in 2023. We do not feel the recession will be very long, or very deep, so the negative effects will be manageable. Looking ahead to the end of 2022 we feel the S&P 500 could see the 4,500 level again because inflation will start coming down and markets will respond positively. Then as we enter 2023 the markets will be under pressure as a real recession hits. We don’t expect to see a full recovery, with the S&P 500 back at the 4,800 level until later in 2023, perhaps even end of year. Getting the timing right on these sorts of economic transitions is never easy and it’s frustrating to think we won’t see a recovery for at least another year, but that’s what we’re seeing in our crystal ball. Historically, it’s not unusual for a two-year recovery when recession is experienced, so Jan 2021 to December 2023 isn’t unreasonable. We’ll do our best to understand the economic gyrations and report them to you accordingly.
All the best,
Barron Financial Group, LLP is a fee-only Registered Investment Advisor regulated by the Connecticut Department of Banking.
This newsletter is for general information only and should not be considered investment advice. Investors should consult with a trained investment professional to discuss their particular situation.